Month: October 2008

Financial Crises and Democracy

Lorenzo Bini Smaghi, a member of the Executive Board of the European Central Bank, gave a thought-provoking speech in Milan last week. In particular, he focused on the role of democratic politics in responding to the financial crisis and, more broadly, in how governments manage their economies. Smaghi begins with the premise that it was a mistake to let Lehman fail in mid-September (not everyone agrees with this, but many people do), thereby triggering the acute phase of the credit crisis. He then asks why this happened.

As subsequent events have shown, in particular when the first rescue package was rejected by the US Congress, opposition to providing the financial sector with public funds came not only from within the government, but also from parliament. The Members of the US Congress, many of whom face voters at the beginning of November, feared that such a decision would compromise their re-election. There was opposition to rescuing Lehman Brothers, therefore, not only from within the Administration, but also from Congress and, more broadly, from public opinion. In other words, the decision was largely the result of a democratic process.

Continue reading “Financial Crises and Democracy” →

U.S. Economy Saved (Temporarily) by Defense Spending

As you probably know by now, GDP declined at an annual rate of 0.3 percent in the 3rd quarter (July-September). Menzie Chinn has a good post at Econbrowser breaking down the components of the GDP numbers. One number jumped out at me: defense spending contributed 0.9 percentage points of GDP growth. Put another way, if defense spending had remained flat in Q3, GDP would have declined at an annual rate of 1.2 percent.

Now, there may be very valid reasons for an uptick in defense spending. For one thing, our military’s equipment is being depleted by the wars (and in some respects the equipment was insufficient to begin with). But I’m not sure we can count on it in future quarters – or that we want to count on it.

Martin Feldstein: Stimulus Should Be Big

Conservative economist and deficit hawk Martin Feldstein is arguing that we need an economic stimulus package now (immediately after the election) that is big ($100 billion won’t cut it) and long. OK, he didn’t explicitly say it should be long, but he did say this:

Previous attempts to use government spending to stimulate an economic recovery, particularly spending on infrastructure, have not been successful because of long legislative lags that delayed the spending until a recovery was well underway. But while past recessions lasted an average of only about 12 months, this downturn is likely to last much longer, providing the scope for successful countercyclical spending.

This is basically what we said in the National Journal and what Simon said in this morning’s testimony. I’m not claiming that Feldstein listens to what we say (I strongly doubt it). But his op-ed emphasizes the fact that most economists from across the political spectrum are on the same page on this issue.

Update: “Business executives and Republicans” are on board, too.

Testimony Before Joint Economic Committee, Today

Here is the written testimony I submitted to the JEC.  In my verbal presentation this morning (5 minutes only, strictly enforced) I stressed the following.

1. The global economy is slowing fast, and likely faces an unprecedented (since 1945) recesssion.  The pressures on emerging markets are intense, and inflexibility in Europe in both policy (Eurozone, I’m talking about you) and labor markets (for almost all the European Union) creates serious macroeconomic vulnerability at this stage.

2. In the US, significant (OK, also unprecedented) countercyclical policies have now been put in place.  In particular, the Fed is running through its anti-deflation playbook (which Mr Bernanke was kind enough to publish back in 2002).  We have no idea how to properly measure the scale, let alone the impact, of this increase in: liquidity, contingent liabilities, actual or potential direct lending to almost everyone in the US, and, via unlimited swap lines to some central banks and new $30 billion swap lines to four emerging markets, to many institutions around the world.

3. So deciding what to do with fiscal policy is very hard.  In other industrialized countries, you can rely on “automatic stabilizers” to a greater degree than in the U.S., meaning that their government spending (and deficit) increases in recession because unemployment benefits and the like are more generous.  In the U.S., we have to make a conscious decision.  And that decision needs to be made soon, within a month or so, because any fiscal stimulus works only with a time lag – and the more you want to do things that definitely raised GDP (like infrastructure), the longer the time lag.

So my recommendation is… (well, read the testimony; the numbers are on the first page; detailed recommendations follow on how to spend, for both immediate impact and longer-term benefits).

Comments welcome – there is still a long way to go, in terms of legislation design and implementation.

Update: If you want to see the actual session courtesy of C-SPAN, go here. (Note there were 8 speakers and the session was two hours long.)

Homeowner Bailout Around the Corner?

News sources are reporting more details on the possible mortgage restructuring plan for distressed homeowners first mentioned by Sheila Bair in her Congressional testimony last week. The basic outlines of the plan are:

  • Lenders would agree to reduce monthly payments to be affordable, perhaps based on a percentage of the homeowner’s income. The reduction could be achieved by reducing the interest rate, reducing principal, or extending the term.
  • If the amount the homeowner could pay would result in a mortgage worth less than the foreclosure value of the house, the loan would not be modified and the lender could foreclose.
  • The government would then partially guarantee the new mortgage and absorb part of the loss if the homeowner defaulted.
  • The numbers of 3 million homes and $600 billion in total mortgage value are being thrown around.

This is roughly consistent with the principles we outlined earlier: the lender gets more than it would have gotten in foreclosure, the homeowner is better off than being on the street, the community benefits because there are fewer foreclosures. There are three key issues that still need to be negotiated.

  1. How much will homeowners be expected to pay? Too much, and the lenders will not have to write down their loans very much, and the government will be on the hook for risky mortgages; too little, and the lenders will not participate.
  2. How do you solve the securitization problem, that is, the current inability of many servicers to modify loans that are owned by other parties? This may require a new law in and of itself (one suggestion here).
  3. How do you decide which homeowners are eligible? If people who are delinquent get cheaper mortgages and people who are struggling but paying on time don’t, the latter will scream. It is still in the interests and hence within the rights of the lender, the delinquent homeowner, and the government to do the deal, but that won’t reduce the indignation.

There are also a couple of enhancements to the program that could be considered. First, shouldn’t the government – by which we mean the taxpayer – get something for its guarantee (besides the satisfaction of knowing that it’s doing what’s best for the country)? The homeowner and the lender are both better off than they would be otherwise (homeowner on the street, lender forced to foreclose), and the government is worse off (because some of these new mortgages will fail). The government could get a share in the future appreciation of the house, for example.

Second, to protect against default by the homeowner on the new mortgage, the government could secure the loan against his or her future earnings, because the government already has an enforcement mechanism it can use: the IRS. This would protect the taxpayer’s interests.

Finally, one note of caution. Loan modifications should work for some proportion of delinquent homeowners, but there are probably millions of homeowners who have no chance of paying any mortgage on their houses that would be acceptable to their lenders. People with option ARMS who made minimum payments and then saw their mortgage rates reset upward by several percentage points will not be able to pay anything close to what lenders will require not to foreclose. In conjunction with any mortgage restructuring plan, there also has to be a plan to manage the flow of properties onto the market, because a flood of foreclosures will only cause prices to plummet further. It seems like there are so many things to do, but that is the price of the situation we are in.

Update: Here’s another proposed solution to the securitization problem.

IMF Creates Special Boarding Lane for 1st-Class Countries

One of the subplots of the global financial crisis has been the return of the IMF to center stage: $15.7 billion for Hungary, $16.5 billion for Ukraine, and $2.1 billion for Iceland, with talks continuing with Pakistan and other countries. The Hungary bailout, for example, looks a bit like the old IMF, which insisted on higher interest rates and fiscal austerity in exchange for loans. These conditions attached to past bailouts have made many countries reluctant to turn to the IMF; in South Korea, for example, domestic hatred of the IMF (the emerging markets crisis of 1997-98 is known as the “IMF crisis” in Korea) makes accepting money from it politically impossible.

In order to loan money quickly to countries that need it, the IMF today announced a new $100 billion Short Term Loan Facility offering three-month loans to countries that are deemed to be financially sound (public and private debt at sustainable levels) but are being buffeted by the financial crisis anyway. These loans will have essentially no conditions, and can be used to bolster foreign currency reserves to protect against currency crises, to recapitalize financial institutions, or for other purposes.

This should be a step in the right direction, but raises two issues. First, the IMF only has about $200 billion in lending capacity, and with over $30 billion allocated to Iceland, Hungary, and Ukraine, and $100 billion for “healthy” countries, it could be approaching that limit fast. G7 countries have already committed trillions of dollars to their domestic economies; $200 billion for the rest of the world could run out quickly, and raising more money from member nations would be politically difficult right now. (The US in particular is never keen to help out international organizations.)

Second, the new lending facility draws another line between the haves and the have-nots of the global economy. (The first line was drawn by the Federal Reserve in deciding who got swap lines – and, by the way, the Fed just made $30 billion each available to Brazil, Mexico, South Korea and Singapore.) Countries with the IMF’s seal of approval get loans with no conditions; other countries get the conditions that have been so unpopular in the past. This is more than a normative issue: in a financial crisis, falling on the wrong side of the line can exacerbate the problems faced by a country or a bank, because it saps confidence further and accelerates capital flight. The IMF has promised not to reveal the names of countries that are rejected for its no-condition loans in order not to destabilize them further, but speculators will speculate. And countries that do not qualify will harbor the same resentments of the IMF (and the perceived global economic order) as ever.

(IMF for Beginners, by The Big Money (from Slate).)

Things That Don’t Make Sense, Airline Edition

We now interrupt our global crisis programming to bring you news from the rest of the economy . . .

Earlier today, the Department of Justice approved the merger of Delta and Northwest, which I believe closed later this evening. In its statement, the Antitrust Division blessed the merger, saying:

the proposed merger between Delta and Northwest is likely to produce substantial and credible efficiencies that will benefit U.S. consumers and is not likely to substantially lessen competition. . . .

Consumers are also likely to benefit from improved service made possible by combining under single ownership the complementary aspects of the airlines’ networks.

Now, for literally years, every expert on the airline industry has been saying that the industry needs less competition, less capacity, and higher prices (bad for consumers), and consolidation is the way to achieve that end. Put another way, if Delta and Northwest actually believed the DOJ’s statement, they wouldn’t have bothered merging in the first place.

I’m not saying that the DOJ should have blocked the merger – not being an expert on the airline industry (although I am an expert on flying on airlines), I defer to those who say mergers are necessary for the health of the industry. But since when did the DOJ become their PR firm?

Financial Crises, Political Consequences

Hard economic times have political consequences, many of them unfortunate.

In Argentina, we’ve already seen the government nationalize the private pension system in what many believe to be a naked grab for cash with only a distant relationship to the rule of law.

In Russia, a central government with a war chest of over $500 billion in foreign currency reserves (at least when the crisis started) now has the power to determine which of the billionaire oligarchs will survive and which will be bankrupted. Yesterday the government provided $2 billion (WSJ, subscription required) to the Alfa Group, Mikhail Fridman’s conglomerate, to avoid save him from giving up his 44% stake in a cellular carrier to Deutsche Bank. On Friday, another billionaire will have to come up with $4.5 billion to avoid giving up 25% of the metals company OAO Norilsk Nickel to Western banks including Merrill Lynch and Royal Bank of Scotland, and will likely turn to the government.

Arguably the government’s power in this situation is analogous to the powers the US has granted to the Treasury Department to choose winners in the financial sector. Still, given the other things we know about Russian politics, it is not too far-fetched to see government money used to protect Vladimir Putin’s political allies, impoverish his opponents or nationalize their assets, and keep Russian assets out of Western hands. (Whether the government will have enough money for the job is another question.)

Another likely reaction of governments faced by financial and economic crisis is a return to (or, in many cases, an increase in) protectionism. Richard Baldwin describes how the current state of global trade agreements makes this not only possible but likely, further hurting the global economy.

Finally, there’s (still) Zimbabwe, forgotten by the world, where power-sharing talks are still going nowhere.

MIT: Class #1 on Global Crisis

Here are the slides I used in the first class, which ran from 4pm to 7pm yesterday.  Tell me if anything about them is unclear.

We went in the deep end.

1. The global crisis is having an impact everywhere – including, the students tell me, making conditions harder for microfinance in Africa or India (I asked: how far flung are the implications?).

2. The bank (and other) recapitalizations have helped, but they have also created additional vulnerabilities.  We talked a great about what is happening in the eurozone, and the kind of policies which can turn that situation around.

3. And right now the risks for emerging markets are serious.  Of course, many of them have sizable reserves and the IMF can help (and is helping).  But scale of this change of sentiment and capital movement out of emerging markets and into … mostly the dollar (and US Treasuries in particular) threatens to overwhelm all normal flood barriers.

If you have questions for the MIT students, please post them here.  We’ll discuss in class, and get back to you as effectively as possible.

Economic Stimulus Proposals: The Data, Please

Economic stimulus is in the air. (Simon, in fact, is testifying on the subject before the Joint Economic Committee later this week.) Menzie Chinn at Econbrowser has a data-heavy post today on multipliers – the impact on GDP of in different types of stimulus (tax rebates, tax cuts, unemployment benefits, etc.). He concludes that the stimulus should include extended unemployment benefits, aid to state and local governments, and infrastructure spending. To the counterargument that infrastructure spending takes too long to have an impact, he shows multiple GDP forecasts, all tending to show a protracted recession (and, note, getting worse with each update). If you read one article about the stimulus, read this one.

(Like Simon argued in the National Journal, but with more data.)

Currency Crisis for Beginners

(One of our objectives is to help non-specialist readers understand what they are reading in the news. Instead of appending everything onto the very long Financial Crisis for Beginners page, I’m going to start doing individual posts and linking from that page to the posts. Advanced readers can choose to skip the “beginners” posts – or they can help improve them through comments.)

In honor of Paul Krugman, recent Nobel Prize winner and “inventor” of the currency crisis, we seem to be experiencing a global currency crisis. This may prompt the question: what is a currency crisis?

Different countries (or regions, like the Eurozone) use different currencies. These currencies generally float against each other, meaning that their relative prices are set by traders on foreign exchange markets, although sometimes they are fixed (meaning just that the central bank acts on the market to keep its exchange rate where it wants it). Changes in exchange rates are normal and are driven by a number of factors, such as interest rates in different countries: a higher interest rate creates demand for a currency, and as with most things higher demand leads to a higher price (meaning that currency has greater value). More generally, a currency’s value should be related to the long-term attractiveness of the economic opportunities available in that currency.

Continue reading “Currency Crisis for Beginners” →

Economic Stimulus and Investing for the Long Term

With recession news getting worse every day (here’s one depressing roundup), there is a high likelihood that the Congress will pass an economic stimulus plan either in a lame-duck session in November or immediately after reconvening in January. General sentiment seems to be against tax rebate checks (Martin Feldstein summarizes the argument that the vast majority of the rebates went into savings, not consumption) and in favor of fast-acting measures like extended unemployment benefits and direct aid to state and local governments to replace lost tax revenues. In addition, however, we (and Larry Summers) think that now is the time to invest in long-term economic productivity, for example through infrastructure projects, in part because we are probably looking at a long recession. Our thoughts are presented under Simon’s name and picture on the National Journal’s Economy Blog, which is hosting a discussion of the stimulus package. Note that even the participant from the American Enterprise Institute favors a stimulus package of between $300 and $500 billion.

Starting to Wonder About Internal G7 Dynamics, Just A Little

The G7 did speak on major exchange rates, over the weekend, as expected. But they only spoke about the yen’s “recent excessive volatility.”  This was about the least they could say under the circumstances, and it is not clear that it will do anything – other than encourage further flows into the dollar.

Why did they not mention the dollar, the euro, and the British pound? One possibility is that they are happy with the appreciation of the dollar and the depreciation (falling value) of the euro and the pound. This would be a bit strange, given that dollar depreciation – from 2002 through the summer – was considered by the G7 to be a reasonable component of the global adjustment process that would put current accounts onto a more sustainable path (yes, notwithstanding “strong dollar” statements from the US.)  The dollar was getting close to what the G7 (and the IMF, who do a lot of the technical work in this regard) saw as a plausible “medium-term” value, at least as measured against a broad basket of currencies.  Now the dollar has taken off (i.e., rising in value against almost all currencies). How does that help with anything?

It could be the case that the Europeans like the depreciation of their currencies, as this will help cushion the recession.  The falling value of the euro makes interest rates cuts in the eurozone less likely, because the European Central Bank (ECB) will see the depreciation of the euro as helping the real economy and also increasing (their) fears about inflation.  But given the ECB’s obsession, even today, with inflation – and thus its unwillingness to cut interest rates, come what may – it might be that depreciation is the eurozone’s best short term hope (as well as its likely medium term future, as sovereign risks materialize for smaller countries).

Still, it would be odd if no one at the G7 table isn’t already raising the dangers of deflation (falling prices), particularly in the US – I’m looking at the representative of the Federal Reserve at this point.  Commodity prices are falling worldwide and now the price of imports into the US will decline sharply.  If this feeds into low prices (i.e., a lower price level, not just slower inflation) then short-term, of course, US consumers benefit.  But if lower prices lead to lower wages, then just think what that does to anyone’s ability to pay their mortgage or any other debt – these are almost always fixed nominal amounts.

When people talk about avoiding the mistakes of the Great Depression, they mean in large part not allowing prices and wages to fall.  And the faster and further that the dollar appreciates, the more likely we are to worry about deflation.

What then are the internal G7 dynamics?  Based on what we saw, and didn’t see, this weekend, I would guess that recriminations and nonconvergent policy views prevail. The spirit of cooperation we saw around bank recapitalizations, just two weeks ago, must have evaporated.  We may not want to rely on the G7 to lead the way.  Can I interest anyone in a G20 summit?

So Much Going on …

One of the challenges of the current financial crisis/credit crunch/recession/whatever you call the mess that we’re in is that there are so many things going on at once – stabilizing the financial system, housing, economic stimulus, regulation, emerging markets crisis, now incipient currency crisis, … Luckily, there are many other smart commentators out there working weekends when we all should be spending more time with our families.

On the topic of regulation and economic stimulus, Mark Thoma cites and expands on Larry Summers, who argues that we need to not just give the economy a boost in the short term, but take advantage of the opportunity to take steps – both investments and regulation – to boost productivity in the long term.

Mark Thoma (again) and Yves Smith both provide roundups and analysis of the currency crisis, which Simon raised a couple of days ago. Quick summary: it could be bad.

So if you can’t sleep, there’s plenty to read and worry about. (Or you could watch the World Series.)